Divergence Theme Questioned
Recent developments have given rise to doubts over the divergence theme, which we suggested have shaped the investment climate. There are some at the ECB who suggest rates can rise before the asset purchases end. The Bank of England left rates on hold, but it was a hawkish hold, as there was a dissent in favor of an immediate rate hike, and the rest of the Monetary Policy Committee showed that their patience with both rising price prices and the resilient economy was limited. The Bank of Japan has already modified its aggressive balance sheet growth and reduced slightly the amount of funds deposited with it that are subject to negative interest rates.
The Federal Reserve officials sounded considerably more confident about the US economy’s underlying strength and rising prices, but this seemed now to be mostly an attempt to ensure that last week’s hike was not a surprise. The FOMC statement and the forecasts simply confirmed the pace of normalization that had been previously signaled.
Moreover, the Federal Reserve has been unable to rebuild its credibility in the sense that investors doubt that the central bank will deliver the rate hikes that it thinks will be appropriate. If investors took seriously that the Federal Reserve would hike rates five more times by the end of next year, the two-year note would not be yielding around 1.30%.
Following the FOMC meeting, the market downgraded the chances of a follow-up hike in June. Judging by the Fed Funds futures strip, about one in nine think the Fed will not hike again. About a third think there may be one more hike, and one third accepts the dots that indicate two hikes maybe appropriate before the end of the year.
Five of the regional Fed presidents speak in the week ahead. Leaving aside Bullard, who seems to be still developing the new approach unveiled last year, and Evans, who leans to the dovish side, most of the other regional president will likely continue to press their case for quicker normalization. However, we again suggest putting more weight on the guidance from the Fed’s leadership, and in the week ahead it means Yellen and Dudley. They may offer a less dovish interpretation of the Fed’s recent decision than the market seems to believe.
Investors may also be concerned that US fiscal policy may not be what they expected. The draft budget proposed by President Trump was expressed little of the populist sentiment seen on the campaign trail and subsequent rhetoric. In many ways, the budget was an expression of longstanding Republican aspirations. Rather than boost infrastructure spending, numerous domestic social programs and foreign aid were cut to make room for increased defense and security spending, including a down payment for the wall that is to be erected on the border with Mexico.
Funds to the Department of Transportation, which would seem to play an important role in the revitalization of America’s infrastructure would see a 13% (nearly $2.5 bln) cut in the president’s plan. The Federal Aviation Administration (FAA) would be privatized. Amtrak funding would also be cut, and several new transit projects would have to be canceled.
Meanwhile, the Republican health care plan as an alternative to the current Affordable Health Care Act (a.k.a. Obamacare) may be voted on before the end of the week ahead. At stake is not only health care, but it is a keystone to the Republican’s larger tax reform efforts. Specifically, the repealing of the taxes that financed the current scheme would free up around $1 trillion over the next decade.
Of course, as most observers recognize, the Senate has other ideas and will likely pass a different bill. The differences will be hammered out in the reconciliation process, which requires a simple majority, which the Republicans possess. It is integral to the GOP strategy to use the reconciliation process to overcome the limitations posed by its slim majority in the Senate.